Sunday, November 29, 2009

Gaming the Gold Bugs Redux

The recent meteoric rise in GLD has ushered in yet another volatility surge, which is just one more example of the positive correlation we tend to see with GLD and implied volatility. As mentioned in Gaming the Gold Bugs, these spikes are usually short lived and experience reversion to the mean once the mad dash for options subsides. Tack on the fact that IV30 is sitting at a hefty premium to 20HV (24% vs. 15%) and it's fair to say volatility sellers have a bit more edge at this point versus buyers.

So last time I mentioned using a 1x2 call spread to exploit the elevated implied volatility as well as place a mildly bearish bet. What about this go around? The big x-factor with current conditions is the fact that GLD has gone virtually parabolic, making it quite difficult to step in and fade the move. Since the 1x2 call spread involves selling naked calls, there can be considerable risk if the underlying rises too far. Though I was comfortable selling naked calls last go around, I'd be lying if I didn't admit the parabolic rise in GLD gives me pause.

To paint a better picture, think of it this way. Flip the chart of GLD upside down and pretend it just dropped about 15-20 days in a row- a veritable falling knife. Would you be comfortable selling some naked puts? If the huge drop in price gives you a bit of pause, then you understand where I'm coming from.

With that being said, let's explore a 1x2 call spread just for kicks. Suppose we buy the Dec 119 call and sell two 121 calls for a net credit of $.25. Consider the risk graphs:
[Source: EduTrader]
If we wanted to make more of a bearish bet, we could potentially use lower strikes (such as 117-119), sell additional naked upside calls, or simply settle with bear call spread.

Friday, November 27, 2009

Chinks in Small Cap Armor

As mentioned previously, there are a few different tools at our disposal when executing relative performance analysis. The first tool I'd like to hone in on is a relative comparison chart. Though this analytical tool can undoubtedly be found in various places on the web, I personally use the one provided on Yahoo! Finance. To access the tool, go to finance.yahoo.com, type in the ticker symbol you want to view in the "get quotes" box, and hit enter. Once it pulls up the information for that security, click on "Interactive" under the Charts section on the left side of the window. Within the chart displayed you can select "compare" and add other securities that you want to use in the comparison.

Within the chart you can compare virtually any time frame, from as short as one day to as long as about 10 years. Consequently, one must necessarily decide the optimal time frame to use for the comparison. Though opinions may vary from trader to trader, choosing the ideal time frame for me comes down to what type of trade you're considering. If you're looking for a day trade candidate, you may the stock's performance over the last day or week. If searching for a swing or position trade, consider the last few weeks to months. Remember there does tend to be a certain degree of "noise" on a day to day basis, so be careful with putting too much emphasis on any one day's performance. The relative strength or weakness of a certain stock or sector becomes more apparent over longer comparison periods.

One of the divergences we've seen in recent weeks has been the relative weakness exhibited by small cap stocks. Consider the following 3 month comparison chart between the IWM and SPY (click image to enlarge).

[Source: Yahoo! Finance]

While the IWM (small cap) was moving in lock step with the SPY (large cap) between Sept. and October 19th, small cap stocks sold off much more aggressively between Oct. 19 and Nov 2nd. Though the SPY has since rallied to new highs, the IWM has failed to even reach its 2009 highs. While large cap stocks were able to stage a strong advance (roughly 7%) in the last 3 months, small cap stocks have struggled to post a measly 2% gain.

Given the recent lackluster performance of the little guys, it's fair to say the bears may be gaining the upper hand in small cap land.

Wednesday, November 25, 2009

Mail Time- Credit Spreads

Let's take a breather from the relative performance discussion and tackle some viewer mail. NGBSTL posed the following question in response to my introduction post, A Primer on Relative Performance.

I enjoy credit spreads b/c my view is they are one of a few ways you can profit from 2 outta the only 3 possible behaviors of underlying (up,down,sideways): so it can either go away from you or slosh around where it is, and you profit in both those instances. My criteria for finding ideal candidates this far has been limited to seeking some sort of technical line of defense between short strike & current price. But I'd love to learn more 'sophisticated' criteria for finding such candidates...maybe a future post? thx!

NGBSTL,

Thanks for the comments and question. The higher probability of profit inherent with selling out-of-the money credit spreads is certainly one of the advantages to using them. The idea of winning the majority of the time is an alluring prospect for traders that hear of this type of strategy (whether it be selling call spreads, put spreads or both). As with most strategies where those on one side of the trade win the majority of the time, we must keep in mind that the occasional losers can easily dwarf the winners. Your success with selling credit spreads isn't so much dependent on how you manage the winning trades, but rather the losing ones. So, I would hope that you have some type of rules in place helping you to minimize losses on credit spreads that go awry.

In terms of finding candidates, I've seen a few different approaches. For directional trades (selling call or put spreads individually), I simply use technical analysis. If I have a strong up trending stock, I'll look to sell put spreads on the dips. For bearish candidates I'm looking for down trending stocks that have rallied to resistance. Bottom line is I have to see some type of bullish or bearish price pattern before I pull the trigger. Implied volatility also plays a part. Ideally I like to be entering when implied volatility is too high and see it diminish throughout the duration of the trade.

The other approach commonly used for Iron Condors, though it could be used for directional trades as well, is simply using the same underlying month to month. You'd obviously want to choose an underlying that has liquid options with tight bid/ask spreads. A good example could be the SPY or RUT. Those that use this approach tend to focus on indexes or ETF's thereby avoiding earnings announcements and other potential company news events that could disrupt the normal ebb and flow of price action.

Here's an example of my two most recent directional credit spreads. The graphics pretty much speak for themselves.

[Source: EduTrader]

Tuesday, November 24, 2009

Comparing Apples to What?

In continuing with the groundwork laid in yesterday's introduction of relative performance, I want to highlight various methods I've used to determine the relative strength of two securities. Suppose I'm considering a trade on an individual company such as Apple Inc. (AAPL). The first consideration is deciding what to compare it to. The three most common comparisons are as follows: Stock to Market Index, Stock to Sector, Stock to Stock. Let's expand on each one.

Stock to Market Index

Since the majority of traders use the S&P 500 Index as the benchmark for market performance, it makes sense to compare the SPX to AAPL to ascertain whether AAPL is outperforming (exhibiting rel. strength) or under performing (exhibiting rel. weakness). The ideal bullish scenario would be AAPL outperforming the SPX. If you preferred to use the Dow Jones Industrial Average or Nasdaq Composite, you could obviously modify which market index you use.

Stock to Sector

Just as I'd like to see AAPL outperforming the SPX, I'd also prefer that it was outperforming the technology sector. If you're unaware of how to chart a sector, you can use the Select Sector SPDRs which can be found on http://sectorspdr.com/. To borrow a commonly cited phrase from an obnoxious market pundit, I'm seeking the "best of breed". Not necessarily from a fundamental perspective, but rather from a relative performance perspective. If AAPL is indeed outperforming its sector than one would think it has a better chance of continuing to increase in value vs. if it were under performing its sector.

Stock to Stock

I've seen two approaches used in choosing which stock to use in the comparison. The first approach is to pick one of the stock's competitors within the same sector. The other approach would be to simply choose another stock you're considering buying in an attempt to identify which one is relatively stronger. In the case of AAPL, perhaps I could use GOOG if I wanted to choose one in the same sector. If, on the other hand, I was also considering a bullish trade on Exxon Mobil Corp. (XOM), there's nothing to say I couldn't use it in comparison to AAPL.

Whether we use one or all of the aforementioned comparisons, the bottom line is we're trying to build a bullish (or bearish) case on the stock in consideration for a directional trade. If AAPL is exhibiting relative strength vs. the broader market, the tech sector, and other competitors, we've got a much stronger thesis for selling put spreads or entering some other type of bullish trade.

Next time we'll explore the various tools/indicators that can be used to actually perform the analysis.

Monday, November 23, 2009

A Primer on Relative Performance


Though I tend to favor delta neutral positions such as iron condors, I still have a smattering of somewhat directional positions within my portfolio. What do I mean by 'somewhat directional'? Well, rather than placing an aggressive position such as long calls or puts, which can be both quite lucrative when right, but quick to punish when wrong, I usually opt to sell out-of-the-money credit spreads. Obviously when I sell a call or put spread I'm making a directional bet, but much less so than if I were to buy calls or puts outright. One of the tools I use to aid in choosing which underlying I want to use for these types of trades is relative strength.

Though the relative performance of two securities can be measured over any time frame, I tend to favor longer term. The rationale being that day to day we often see minor aberrations in price that are nothing more than noise. No sense making a mountain out of a mole hill. It's when relative strength continues over weeks to months that I begin to take notice. From a relative performance standpoint, what can we surmise about the following 2 securities?

ABC has increased 5% over the last two weeks.
XYZ has increased 2% over the last two weeks.

We could say any of the following: ABC is outperforming XYZ. ABC is exhibiting relative strength. XYZ is underperforming ABC. XYZ is exhibiting relative weakness.

If you subscribe to the notion that strength begets strength and weakness begets weakness, then naturally you would look for bullish trades on ABC or bearish trades on XYZ. In other words, when bullish we seek relative strength and shun relative weakness. When bearish we seek relative weakness and shun relative strength. Next time we'll explore a few different methods used to perform this type of analysis.

Friday, November 20, 2009

Nailed It

In the Gaming the Gold Bugs post, we explored using a call ratio spread to exploit a mildly bullish move as well as elevated implied volatility in GLD. Given that today is the last trading day for November options, let's analyze how the ratio spread would have played out.

At trade inception GLD was trading around $107 with implied volatility ($GVZ) spiked up to 26%. We mentioned each volatility spike has been fade able over the past few months. Since then GLD has continued it's surge, rising as high as $113. Volatility has subsided and is currently residing around 24%


Trade Inception:
Long (1) November 109 call @ $1.30
Short (2) November 111 call @ $.78
Short (1) November 113 call @ $.50
Net Credit $.76

[Source: EduTrader]

Based on the expiration risk graph, the maximum profit will be realized if GLD is residing at $111. As long as GLD remains below $113.50, we capture some type of profit. This is where the position stands currently.

November 109 call @ $2.85 (profit = $1.55)
November 111 call @ $.90 (loss = $.12 x 2 = $.24)
November 113 call @ $.03 (gain = $.47)
Net Gain = $1.78

Since we're above $111, one would need to close the trade sometime today to avoid being assigned on the extra naked calls. Although we could say all's well that ends well, truth is GLD was getting a little too bullish when it rallied up to $113 on Wed. Given that these call ratio spreads involve shorting more options than you are buying, there is upside risk you have to worry about if the stock rallies too far. Consequently, you must remain ever vigilant in monitoring the position and managing risk.

Wednesday, November 18, 2009

Narrow Escape

Looks like VIX November settlement came in at $22.54. Remember you can view the settlement price via CBOE's Index Settlement Values page or via the ticker VRO. As far as I can tell the CBOE has yet to publish the data, but VRO is currently at $22.54. Looks like the opening price for the cash VIX this morning was $22.35, so the settlement price seems in line or perhaps a minor gift to those who held their short 22.50 puts into expiration. You don't cut it much closer than settling $.04 out-of-the-money.
[Source: EduTrader]

I received a question regarding selling call spreads, such as the 32.50-35, on the VIX via December options. Let me preface my answer by stating that I can't remember the last time I traded call spreads on the VIX, so my answer is coming from an objective bystander's point of view, not from a extensive experienced one. First off, since selling call spreads is a neutral to bearish bet, you'd obviously need to have that type of bias right now on VIX December futures before considering the trade. Here's how the volatility landscape stands right now:

21 day HV on SPX = 21%
Cash VIX = 22%
December VIX Futures = 24.8

So, the Dec futures are sitting around a 3 point premium to the cash. If you're of the opinion that the cash VIX is going to remain in the low 20's, and in turn Dec futures will continue to diminish over the next month, then a selling call spreads sounds feasible. The other two considerations are timing and potential profit.

Timing: Based on the nature of the VIX, particularly over the past few months, I think it's fair to say the ideal time to sell call spreads is immediately after the VIX spikes and forms a short term top, such as numbers 1-5 in the chart below (with a 10 day MA and bollinger bands). Under those circumstances you're likely to get some type of pop in the futures thereby increasing call premiums. Given that the VIX has already dropped significantly in the last 2 weeks, I'm not sure I'm in love with the timing. It would be nice to see some type of pop in the VIX before selling call spreads.
[Source: EduTrader]

Potential Profit: The other consideration is whether or not there is sufficient premium in the call spreads to make it worth your while. Currently I'm seeing the following:

Dec 32.50- 35 call spread @ $.20 credit
Dec 32.50 - 37.50 call spread @ $30 credit
Dec 30-35 call spread @ $45 credit

Based on current prices we're not dealing with a lot of potential credit. Consequently, Dec call spreads don't seem all that alluring to me at this point.

In reviewing my posts the last few weeks, it seems I've been fixated on the VIX and volatility. This is due primarily to my responses to the Volatility quiz as well as VIX expiration. For those of you that are tired of hearing volatility this and volatility that, I'll see if I can mix things up a bit going forward.

Tuesday, November 17, 2009

VIX Expiration Dilemma

Since tomorrow is expiration for VIX options and futures, today is the last day to adjust/close out any November VIX plays trader's may have on their books. Last Thursday, I mentioned selling the November VIX 22.50 puts for $.60 credit. Fortunately the VIX has since stabilized causing the 22.50's to remain out-of-the-money. Right now the cash VIX is sitting around 23.10, with November futures trading a bit higher at 23.40. Remember, the futures will converge to the cash by tomorrow's settlement, so the discrepancy between the two will dissipate throughout the day.

Here's the dilemma: do I close out the naked puts today to lock in whatever profit I've accumulated thus far? Or, do I go ahead and ride it into tomorrow's settlement and hope we settle above $22.50, thereby capturing my entire potential profit?

It's worth mentioning this is the dilemma facing any trader short slightly out-of-the-money puts with one day remaining to expiration.

Hopefully you all know there is not one "right" answer. Trading is about trade-offs, so let's explore those associated with this particular play.

1. Close the puts sometime today to avoid the potential drama/ quirks of VIX settlement.

Pro: Closing the trade locks in the majority of potential profits and eliminates any remaining risk.
Con: Obviously if you close them now you fore go any remaining profit.

2. Hold the trade through tomorrow's open and subsequent settlement in an effort to realize max profit. This occurs if settlement price for VIX options is greater than $22.50

Pro: I get to realize my enter max profit.
Con: If the VIX tanks today and closes near or below 22.50 OR if it remains around 23 but we get a skewed settlement tomorrow, you run the risk of not only giving back what profits you've accumulated, but also incurring a loss in the trade.

What to do, what to do....

To me it's a no-brainer. If I can snatch those puts back for $.15 or less, I'm outta here... Adios amigo. In the long run, those last few cents aren't worth it in my opinion. Now, I will say if the VIX continues to trend up today, I may ride close to the bell in an effort to buy them back for as cheap as possible ($.10 or $.05), but it really depends upon market conditions.

If you think the potential risk of a crappy settlement is worth making the last $.10 or $.15, then by all means, ride to expiration. Just keep in mind you're going to get steamrolled every once in awhile. That I can almost guarantee!

Monday, November 16, 2009

Overcoming the Gap Factor

In Historical Volatility: The Gap Factor, I explored the affect that large gaps in the underlying price can have on historical volatility. Basically, these gaps artificially skew historical volatility too high such that it overstates true realized volatility for as long as the gap remains in the calculation. Take a look again at the graphic displayed in the original post (click any image to enlarge):
[Source: Livevol Pro]

Notice how the gaps that occurred during the last four earning announcements (the blue "E") caused an immediate surge in historical volatility. Once these gap days fall out of the equation (30 days later), historical volatility usually tanks, bringing it more in line with reality. This gap factor presents an interesting dilemma for those trying to use IV-HV analysis. That is to say, it is difficult to get an accurate read on whether IV is trading too high or too low compared to HV if indeed historical volatility is skewed extremely high.

The logical fix is to use a historical volatility reading that doesn't include the gap in its calculation This can be done by assessing a shorter term reading. For example, if the 30 day HV is skewed because of the gap, try looking at a 20 day or 10 day HV reading. If the gap occurred at least 11 or 21 days ago, it shouldn't be included in one or both of these calculations. Consider the following price and volatility chart on AMZN.
With HV30 around 75% and IV30 around 40%, the options seem cheap. However, is this a fair comparison? The answer is no. HV30 is skewed because of the monster earnings gap, it would be wise to look at a shorter HV measurement. We could try HV20, but since the gap took place within the last 20 trading days, HV20 will also be skewed. How about HV10? Let's take a look.
Now that the gap is out of the calculation you can see how low realized volatility truly is. Currently HV 10 is sitting around 25% or so,much lower than the 75% originally stated by HV30. With the HV10 light shed on things, options don't seem so cheap after all.

Some may argue 10 day historical volatility can be quite erratic since it encompasses such a small data set. As for myself, I'd rather deal with a more erratic reading than use one that is skewed way too high.

For other posts touching on historical volatility, readers are encouraged to read:

Thursday, November 12, 2009

Volatility Landscape and VIX Option Play

Per my comments on monday's VIX Sonar post, I've been stalking potential short put plays with the November VIX options. I went ahead and pulled the trigger yesterday on the NOV 22.50's, selling them at $.60 credit. Those of you who follow me on twitter are probably already aware of the trade (I tweeted it yesterday), so let me use today's post to elaborate on the rationale, starting with a recap of the current volatility landscape on the S&P 500 as of yesterday.

21 day HV = 21
Cash VIX = 23
Nov VIX Futures = 23.7

As the 21day historical volatility states, the S&P has been realizing around 21% volatility for the past few weeks. With last weeks rally, the VIX has taken it on the chin dropping to sub 23 intraday yesterday, which puts it pretty much in line with 21 HV. Remember, the VIX generally trades at a premium to realized vol, especially in 2009. Tack on the fact that the VIX was oversold by most measures, and I think we had a pretty solid thesis for selling puts.

As the chart below shows, the VIX was roughly 11% below it's 10 day simple moving average, as well as oversold based on the modified stochastic displayed (click image to enlarge).

[Source: EduTrader]

The following graphic displays the risk graph of the short NOV 22.50 put with it's corresponding profit/loss zones:


Follow me on Twitter here.

For related posts, readers can check out:

Wednesday, November 11, 2009

Volatility Skew and SPY Ratio Spread Update

In my post highlighting the volatility skew of SPY options, I introduced the idea of selling ratio spreads to exploit the skew as well as profit from a mildly bearish move in the underlying. You can view the post here. Fast forward two weeks, mix in a robust rally in the SPY as well as diminishing volatility, and what do we have? While I let the suspense build, let's recap the numbers from trade inception:

Oct. 28th, SPY @ $104
Buy (1) Nov 103 put for $2.00
Sell (2) Nov 100 puts for $2.40 ($1.20 apiece)
Net Credit = $.40

Take a gander at the risk graph from trade entry (click image to enlarge):

[Source: EduTrader]

Here is the current risk graph:

So what do we have? Due primarily to the rally in the SPY and partially to the declining volatility (VIX dropping from 31 to 23), the puts in play are far OTM and almost worthless. At this point we have three options:

1. Close the trade to lock in the majority of the net credit (roughly $.30)
2. Ride to expiration in an effort to realize the entire net credit (occurs if SPY remain above $103)
3. Ride to expiration in the hopes that the SPY drops below $103 into my "larger" profit zone.

The outcome of this particular trade sheds insight into one big advantage of the 1x2 put spread. Even though the SPY have risen considerably (the WRONG way), we were still able to garner a mild profit on the trade.

EDIT: By the "WRONG" way, I simply mean the direction that does not result in what I consider the ideal or largest profit.

For related posts, readers are encouraged to view the following:

Tuesday, November 10, 2009

Implied Volatility: The Supply-Demand Factor

The fourth and final question from the volatility quiz cut to the heart of the matter by asking what it means when implied volatility declines. The results weren't as stellar with this question as only 71% answered correctly by stating that when implied volatility increases, demand for that option has increased.
My guess is that some aren't clear on how supply and demand work to influence option prices, so let's see if I can shed some insight based on my understanding. Within the options market, as with any competitive market, prices fluctuate as a function of supply and demand. More demand than supply, prices typically rise. More supply than demand, prices typically fall. Just because option traders may use a theoretical pricing model, such as Black-Scholes, to derive a fair or theoretical value for each option, doesn't mean that the option prices won't fluctuate above or below that "fair value" based on supply and demand.

Assuming all other variables stay constant (time to expiration, stock price, interest rates, etc...), we could make the following assertions:

If demand for an option increases, option prices will increase. If option prices increase, implied volatility will increase.

If supply of an option increases, option prices will decrease. If option prices decrease, implied volatility will decrease.

For example, with the S&P 500 Index (SPX) currently trading around 1095, let's say the December 1000 put is worth $6.50. If we plug this value into an options calculator we can see if the 1000 put is trading at $6.50, implied volatility would be 26%

[Source: CBOE]
Let's say a big buyer comes in and aggressively buys 10,000 contracts of the Dec 1000 put. Due to this increased demand, suppose the put rises in value to $12. If all other variables remain constant, the implied volatility of the put would rise to 33%.

Monday, November 9, 2009

VIX Sonar

With VIX expiration for November options on the horizon (next Wednesday), I'll be stalking the fear index in the coming days for a few potential plays. Given that the VIX is quickly becoming a tad oversold, we may have a short put play in the cards. It's only been a week since the VIX mega spike and boy have the tables turned. Kudos to anyone that had the guts to fade the spike via short calls, call spreads, short VXX et. al. Though I sold some SPY put spreads and shorted some VXX, it certainly wouldn't have hurt to have sold some more.

Looks like we had some sellers of November 25 puts to the tune of 6K contracts per today's Volatility Sonar Report. If the VIX comes in a bit more and the Nov 22.50 puts get some more juice, my interest may impel me to action.

Saturday, November 7, 2009

Economists and Chaos

So I just wrapped up my reading of Ronald Reagan: How an Ordinary Man Became an Extraordinary Leader by Dinesh D'Souza. All in all I rather enjoyed it and learned quite a bit. I'll leave you with one last excerpt that concurs with my thoughts on economists.

The president took an equally jocular attitude to the criticism unleashed against his policies by the nation's leading economists. He was reminded, he said, of the three gentlemen who had just died and were standing at the gates of heaven to be admitted. One was a surgeon, the other an engineer, and the third an economist. They had all fulfilled the entrance requirements, but it developed that there was room for only one at that time. So St. Peter said, "I'll tell you what. I'll pick the one who comes from the oldest profession." The surgeon stepped forward and said, "I'm your man. Right after God created Adam, he operated. He took a rib and created Eve. So surgery has to be the oldest profession." The engineer said, "No. You see, before God created Adam and Eve, he took the chaos that prevailed and built the earth in six days. So engineering had to precede surgery." The economist finally spoke up and said, "Just a minute. Who do you think created all that chaos?"

For related posts, readers are encouraged to check out:

Friday, November 6, 2009

Historical Volatility: The Gap Factor

If you missed last weeks Volatility Quiz, you can check it out here.

Similar to question number two, quiz question three also tested your ability to read a volatility chart to ascertain the relative value of option prices. Roughly 90% of you answered correctly stating that options seemed under priced. Take another gander at the question and corresponding volatility chart:
[Source: Livevol Pro]

HV20 has recently surged up to 70%, while IV30 has fallen to about 35%. If you were of the opinion that the stock was going to continue to exhibit 70% volatility, then options are a steal at 35%. We may consider initiating a long volatility strategy via a straddle or calendar spread. In addition to being "cheap" compared to HV, implied volatility also seems cheap relative to itself as it's sitting at its lowest levels in the last 6 months.

One notable issue with using historical volatility in an effort to forecast future volatility is the fact that HV can be artificially skewed by large gaps in the stock price. More times than not these gaps are relatively short term events, such as earnings announcements, not indicative of the day to day volatility actually realized by the stock. These large moves can skew the HV reading for as long as they remain in the calculation. Once this gap, which we can consider an outlier when compared to the normal day to day moves, falls out of the calculation HV tends to revert back down to more "realistic" levels. Consider the following chart displaying 20 day historical volatility of First Solar Inc (FSLR).
Notice the sharp increase in HV when each earnings gap enters the equation (the blue "E" icon). 21 days later as the gap falls out of the equation (the red "Out"), notice the sharp decrease in HV as it reverts back to a more accurate reflection of the day to day volatility.

For the chart displayed in quiz question #3, you can see the HV 20 was skewed artificially high to 70% due to an earnings gap. Truth is 70% is probably NOT how volatile the stock will be going forward. Make sure you keep this "gap factor" in mind anytime you're assessing volatility charts.

Next time I'll explore a few ideas for handling this artificial skew.

Wednesday, November 4, 2009

Gaming the Gold Bugs

Given the recent surge in gold prices, we've seen an up tick in chatter, price prognostications, and volatility forecasting concerning the precious metal. So... why not join the fray and give a few thoughts of my own?

Over the past few months, GLD has exhibited low levels of volatility with 21 day HV remaining steady around the 14 to 16% range. However, each time we've seen GLD's price breakout in continuation of its uptrend there has been a veritable flock to options which has caused a spike in implied volatility. The most recent two spikes have turned out to be short lived events that provided an opportunity for volatility sellers to exploit mean reversion. If you believe that trend will continue, you may consider entering short vol strategies to play the current IV spike.

[Source: Livevol Pro]

Though there are a plethora of potential volatility plays to choose from, let's focus on a mildly bullish one, the call ratio spread.

Long (1) November 109 call @ $1.30 (IV = 22%)
Short (2) November 111 call @ $.78 (IV = 23%)
Net Credit = $.26
[Source: EduTrader]

The trade benefits from a decline in implied volatility as well as time decay. Because it involves selling a naked call, there is upside risk if the stock rises too much, so you obviously need to make sure you're comfortable selling naked calls.

Here's a potential variation that brings in more credit, while increasing upside risk.
Long (1) November 109 call @ $1.30 (IV = 22%)
Short (2) November 111 call @ $.78 (IV = 23%)
Short (1) November 113 call @ $.50 (IV = 24%)
Net Credit = $.76

Tuesday, November 3, 2009

The Tempest and Volatility Analysis



The second quiz question tested your ability to perform IV-HV analysis to ascertain whether options seemed cheap or expensive.

83% of you nailed it by answering that options seem overpriced.

In comparing implied vs. historical volatility we're trying to get a sense as to whether options (implied vol) are over or underpricing the amount of volatility we're expecting the underlying to realize throughout the duration of the trade. Rather than randomly guessing how much volatility a stock is expected to realize, most traders use historical volatility as a gauge. What better way to forecast future volatility than by looking at what's happened in the past?
As Shakespeare stated in The Tempest:
Whereof what's past is prologue, what to come,
In yours and my discharge.
If indeed past is prologue, then historical vol may well give us an accurate read of how volatile the stock will be going forward. Thought it's probably better than guessing, there are caveats aplenty to this method. First and foremost being that historical vol doesn't take into consideration upcoming earnings announcements. If you drive a car long enough by looking in the rear view mirror instead of through the windshield, you're bound to crash and burn at some point.
[Source: Livevol Pro]
Within the volatility chart displayed above, you can see implied volatility (68%) trading much higher than historical volatility (40%). If you were of the opinion that the stock was going to continue to realize 40% vol, then you'd prefer to sell options as they're too pumped up.

For related posts, readers are encouraged to check out:

Monday, November 2, 2009

The Cycle of Implied Volatility

Much to my satisfaction the polls seemed to work without a hitch. Thanks to those of you who participated.

My thoughts on the outcome?

Well, I'm pleased to state that the majority of us grasp the basics of reading a volatility chart. Let's delve into the answers and see if I can shed some insight on the rationale behind each answer, starting with question #1.
So 90% answered correctly in stating that quarterly earnings announcement are the usual catalyst behind the cyclical rise and fall of implied volatility. I'm hoping the rationale is obvious, but for those not yet comfortable with the nuances of option prices, allow me to elaborate. The following two assertions have helped me better understand options:

Options are Insurance
Volatility is the Price of Insurance

Just as any insurance company adjusts the price of insurance based on the risks inherent to each individual client, the market place adjusts the price of each option based on the perceived risks of the underlying stock going forward. Though an actual insurance company thinks of "risk" as likelihood of injury or sickness, option traders think of "risk" as likelihood of a large move in the underlying stock. If the stock is perceived to have higher risk of a large move going forward, options become more expensive (implied volatility increases). If the stock is perceived to have less risk of a large move going forward, options become cheaper (implied volatility decreases).

[Source: Livevol Pro]

So options are continually seeking to price in or discount how much volatility a stock is likely to realize in the future. Since earnings announcements almost always cause an increase in realized volatility, options seek to accurately price in this uptick in realized vol before it happens. Thus, there is almost always a rise in implied volatility in anticipation of the event.

What about after earnings?

Typically stocks revert back to their normal price behavior post earnings. With the catalyst in the rear view mirror, options also revert back to pricing in a stocks normal realized volatility. So, we usually see a sharp decrease in implied volatility to bring it more in line with reality, or at least the reality option traders expect to see going forward. Naturally this cyclical rise and fall in implied volatility should be taken into consideration by volatility traders seeking to buy low and sell high.